Knowing how to analyze a balance sheet is a must to make good investment decisions.
You want to invest in companies that are in good financial shape.
Learn everything you need to know about a balance sheet this article.
What is a balance sheet?
A balance sheet is a financial statement that shows you 3 things of a company at a specific point in time:
In child language, a balance sheet shows you what a company owns and owes.
Balance sheet = snapshot
It is very important to understand that a balance sheet is a SNAPSHOT of a company’s financial health at a certain point in time.
This is a fundamental difference compared to an income statement and cash flow statement as these statements are measured OVER a period of time.
Balance sheet = snapshot —> at a certain point in time
Income statement and cash flow statement = video —> measured over a period of time
This also means that a management with bad intentions could try to fine tune their balance sheet to look more healthy. That’s why I prefer to invest in companies with an integer management and skin in the game.
The assets of a company show you everything the company owns.
A distinction can be made between current assets and non-current assets.
Current assets: assets that can be converted into cash within 1 year
Examples of current assets: cash and cash equivalents, short-term investments, accounts receivable and inventories
Non-current assets: assets that are harder to convert into cash
Examples of non-current assets: buildings, stores, goodwill (premium paid to make an acquisition) and patents
A company’s assets are always ranked from most liquid to least liquid:
Questions to ask yourself about a company’s assets
How much cash and cash equivalents does the company have (the more, the better)?
How much goodwill does the company have (the less, the better)?
Does the company have a lot of intangible assets?
The liabilities of a company show you how much the company owes.
A distinction can be made between short-term liabilities and long-term liabilities.
Short-term liabilities: a financial obligation that has to be paid within 1 year
Examples of short-term liabilities: short-term debt and accounts payable
Long-term liabilities: debt that has to be paid > 1 year
Examples of long-term liabilities: long-term debt and pension plans
It goes without saying that you don’t want to invest in companies which have too much debt.
Just like a company’s assets, liabilities are also ranked from most liquid to least liquid:
Questions to ask yourself about the company's liabilities:
Does the company have more short-term than long-term liabilities (bad sign)?
Does the company have more cash than short-term debt (good sign)?
Are total liabilities increasing or decreasing? And why?
The shareholders equity shows you how much money the owners (shareholders) have invested in the company.
You can calculate the shareholders equity of a company yourself very easily:
Shareholders equity = Total assets - Total liabilities
In general, there are 3 categories of shareholders equity:
Contributed capital: the amount shareholders have invested in the company to buy their stake
Retained earnings: profits a company has reserved to reinvest in the business
Treasury stock: cash the company uses to buy back its own shares
Questions to ask yourself about the company's shareholders equity:
Does the company have a lot of retained earnings (good sign)?
Are there a lot of preferred stocks (bad sign)?
Does the company buy back shares (good sign)?
Great ratios to analyze a company’s balance sheet
You’ve now learned that you should invest in companies which are in good financial share.
Just like Terry Smith, I like to look at 2 ratios to determine the healthiness of a balance sheet:
Net debt / free cash flow
This ratio shows you how easily a company can pay back the interests on its outstanding debt.
You can calculate it as follows:
Interest coverage = (EBIT / Interest payments)
The higher this ratio, the better. I prefer to invest in company’s with an interest coverage of at least 10x.
Net Debt / Free Cash Flow
This ratio shows you how many years it would take the company to pay down all its debt when it would use all available free cash flow.
The formula for this ratio is very obvious:
Net Debt / Free Cash Flow = (Net Debt / Free Cash Flow)
The lower this ratio, the better. Personally I prefer companies with a Net Debt / Free Cash Flow lower than 4.
That’s it for today. Here’s what you should remember:
A balance sheet tells you what a company owns and owes
The balance sheet consists of 3 parts: assets, liabilities and shareholders equity
The interest coverage and net debt / free cash flow are 2 great ratios to analyze a balance sheet
Next week we will teach you how to analyze an income statement.
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About the author
Compounding Quality is a professional investor which manages a worldwide equity fund with more than $150 million in Assets Under Management. We have read over 500 investment books and spend more than 50 hours per week researching stocks.
Thanks for share your knowledge
By the way, very useful text!!